China government firm’s default shocks market — Is more to come?

LauraHe

HONG KONG (MarketWatch) — Chinese power-equipment maker Baoding Tianwei Group made history this week, becoming the first-ever Chinese government-owned company to default on its debt.

The news came just one day after another milestone, in which Kaisa Group Holdings
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became the first Chinese real-estate developer to default on a U.S.-dollar-denominated bond. But it was the Tianwei case that holds far greater implications for Chinese markets: State-owned enterprises (SOEs) such as Tianwei are traditionally seen as enjoying implicit government support and therefore possess lower default risks.

The news has stoked concerns about rising credit risk in the country, with analysts now warning of more defaults to come, and even the likelihood of a major credit crunch.

Landmark event

In a report Tuesday, China’s largest investment bank — China International Capital Corp. (CICC) — described Tianwei’s default as a “landmark” in the history of the nation’s bond market, although the 85.5 million yuan ($14 million) bond interest payment it has missed is relatively small in size.

Failure to repay public debt was once practically unknown in China, but that changed last year, when Shanghai Chaori Solar Energy became the first Chinese firm to default on a corporate bond. But although the market has now had time to get used to the idea of Chinese defaults, and although Tianwei’s financial difficulties had been widely reported even back before Chaori defaulted, its inability to honor its bonds has surprised the market, CICC said.

The report notes that Tianwei is a fully-owned subsidiary of China South Industries Group Corp., one of China’s largest military-defense companies. Just as importantly, the main underwriter for the bond was China Construction Bank
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one of China’s largest state-owned lenders.

Based on past experience, investors assumed that the government would ultimately come to the rescue.

“The impact of Baoding Tianwei’s default may be unprecedented,” the Beijing Business Today newspaper reported Wednesday, quoting analysts from Guotai Junan Securities
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as saying that the event has “broken the presumption that SOEs have lower default risks.”

More to come?

As CICC sees it, one of the lessons of the Tianwei default is that quite a few struggling Chinese companies, no matter whether they are privately owned or state-owned, are facing great difficulties in successfully refinancing their debt.

The greater concern, CICC said, is that China might face more “credit events” in the coming quarter, given some of the maturities on the calendar, and further such cases will heighten market fears. This, in turn, will widen credit spreads, and “the marketization of credit default is accelerating,” the CICC note concluded.

In another recent report, Standard & Poor’s also pointed to the potential for more Chinese defaults this year amid worsening liquidity and heightened refinancing risks, with property developers especially susceptible due to the long-running downturn in the real-estate market.

On the other hand, Fitch Ratings believes Beijing will only allow the small state-owned entities with less strategic importance to default, as “controlling systemic risk remains a top priority for the Chinese government while the economy remains soft.”

The default of Tianwei, which is a relatively minor entity of its larger SOE parent China South Industries, “fits the Chinese government’s intention to allow isolated cases of financial risk and give market forces more say in the economy,” Fitch said in a report Wednesday.

Rather than hurt the markets, allowing more SOEs to default will “instill credit discipline and facilitate capital reallocation,” as well as aid the government’s push for financial reforms, Fitch said.

Besides, the government could still intervene to save firms “on a selective basis” as they measure the impact of each default on the capital markets and the broader economy, it said, adding that increased volatility in the market would make such interventions more likely.

For now at least, the Chinese bond market seems to be siding with Fitch’s view. The yields on both high-grade and low-grade securities were “holding steady,” seemingly indifferent to Tianwei’s default, Guotai Junan Securities said in a note on Wednesday.

In terms of factors supporting the market, Guotai Junan cited “exceptionally ample” liquidity after fresh policy easing on Sunday from the People’s Bank of China (PBOC).

The credit crunch is at hand

Writing back in January, Merrill Lynch analysts said that there is no doubt the Chinese government has “ample resources” to avert any meaningful potential default.

“Actually, given the debts are mostly [yuan-denominated] debt, the government in a way has unlimited resources to conduct bailouts because, worse comes to worst, the PBOC can always print” money, they said.

However, such state guarantees would strengthen moral hazard and make the financial system more brittle, and China now looks set to apply some “tough measures” over the next couple of years, including addressing the central government’s implied backstop of shaky local-government debt.

Since the “power-consolidation period” for China’s new leadership appears to be largely over, President Xi Jinping’s administration will have more tolerance for disturbance to growth and a greater willingness to forgo short-term growth for long-term structural reforms, Merrill Lynch said.

As a result, a “credit crunch” in China is “a high-probability event,” the analysts said, and although the timing is difficult to predict, 2015-2016 can be considered “the danger zone” in terms of debt defaults and overall financial-system stability, as the government finally moves to address difficult reform issues.

“In theory, the government can always achieve a fine balance between addressing moral hazards and maintaining stability,” the analysts said. But in practice, they warned, it is “extremely difficult” to achieve those goals, especially in terms of China’s massive shadow-banking sector.

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